The S-corp election is the most commonly recommended tax move for a profitable small business, and for good reason. Profit distributed above a reasonable salary avoids self-employment tax, which on meaningful profit is a substantial annual saving.
The part that gets less attention is the word reasonable.
What the rule actually requires
An S-corp owner who works in the business must pay themselves a reasonable salary for the work they perform, subject to payroll tax, before taking distributions that are not.
“Reasonable” is not a figure you choose based on what leaves the best result. It is a legal standard, measured against what the role would command in the open market. The IRS has consistently pursued owners who paid themselves little or nothing while taking large distributions, and courts have consistently agreed with the IRS.
The consequence of losing that argument is that distributions get recharacterised as wages. Back payroll tax, interest, and penalties follow — and because payroll tax was the entire point of the election, the outcome can be worse than never having made it.
Where the number comes from
A defensible salary is built from evidence, not instinct.
Start with what the role actually is. An owner who is the primary revenue generator, manages staff, and sets strategy is performing several jobs, and the salary should reflect the composite. An owner who has genuinely stepped back to a passive ownership role is in a different position — but “passive” has to be true in fact, not just in the way the payroll is run.
Then find comparables: published compensation surveys, industry data, what you would have to pay someone to replace you. The figure that emerges is usually higher than owners expect and lower than the total profit, which is the point.
Document it at the time
The single most useful thing you can do is write down the reasoning in the year you set the salary.
A short memo recording the role, the comparable data used, and the resulting figure costs almost nothing to produce contemporaneously. Reconstructed three years later under examination, the same reasoning carries far less weight — and the absence of any documentation invites the examiner to substitute their own number.
When the election stops making sense
The election is not free. It brings a separate return, payroll administration, and a reasonable compensation obligation that consumes part of the profit before any saving begins.
Below roughly $50,000 of net profit, those costs frequently exceed the benefit. There is a range where it is genuinely marginal. Above it, the saving is real and durable.
The mistake we see most often is not making the election too late — it is making it too early, on the strength of general advice, and then setting the salary too low to make the arithmetic work. That combination is the one that draws attention.
If you have an S-corp and cannot immediately say how your salary figure was arrived at, that is worth an hour of someone’s time before it becomes worth considerably more.